Options and Warrants

Options

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or to sell a parcel of shares at a specified price on (or before) a specified date.

There are two types of options traded on the ASX: call options and put options.

Call options give the taker the right, but not the obligation, to buy the underlying shares

Put options give the taker the right, but not the obligation, to sell the underlying shares

You can trade options over most of Australia's largest companies, including News Corporation, Telstra, BHP Billiton and the major banks.

Advantages of options trading

Risk management

A simple strategy is to use put options which allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide

By buying a call option, the purchase price for the shares is locked in. This gives the call option holder until the expiry date to decide whether or not to exercise the option and buy the shares. Likewise, the buyer of a put option has time to decide whether or not to sell the shares.

Ease of trading

The ease of trading in and out of an option position makes it possible to trade options even if there is no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options and vice versa. Either way the holder can sell the option prior to expiry to take a profit or limit a loss.

Leverage

Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risk than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.

Diversification

ASX's options market allows investors to build a diversified portfolio for the same or even lower initial outlay than purchasing shares directly.

Income generation

Share holders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is the possibility that they have to sell their shares to the buyer of the option at the exercise price. This is called a 'covered write' strategy.

Disadvantages of options trading

Options are not without a higher level of risk and therefore may not be appropriate for everyone.

Time value erosion may adversely affect the price of bought option positions even if the underlying instrument moves in the desired direction.

As options can be used as a leveraging tool, losses may be magnified and created quickly.

Options have a finite life and need to be monitored closely, with a great deal of observation and maintenance.

Warrants

Warrants are a form of derivative issued by a bank, government or other financial institution and traded on the ASX and Chi-X.

They allow investors to trade an underlying instrument, such as shares, without having to own the shares outright.

There are different types of warrants available for trading or investment including Self Funding Instalments, trading warrants, MINIs, barrier warrants, commodity warrants, currency warrants, structured investment products and endowment warrants. Some warrants have higher risk/return profiles than others.

Warrants can be either call warrants or put warrants:

Call warrants benefit from an upward price movement in the underlying instrument

Put warrants benefit from a downward trend

Advantages

Some warrants, such as instalments, allow investors to gain the major primary benefits of share ownership including:

Participation in capital movements in the shares

Receipt of dividends and franking credits

Instalment warrants, put simply, are a loan to buy shares without the obligation to repay the loan. You only have to make an initial payment and the final payment is optional and payable at a later date.

Self Managed Superannuation Fund (SMSF) members can use instalments to legally gear their fund.

Disadvantages

Some warrants have features that make them riskier than others.

Time value erosion may adversely affect the price of a warrant even if the underlying instrument moves in the desired direction.

Contact us to seek specific advice about the risks and features of particular warrants.